LME Warehouse Reform: The Drumbeat Grows Louder

It’s been six months since my last blog entry and there has been a significant increase in activity around the London Metal Exchange (LME) warehouse issue.   Other entities have spoken out, including Southwire, The Beer Institute and Eurofer in Europe.  This widens the metals in question to copper, steel, zinc, tin and nickel.  With such a broad spectrum now in the mix, the LME and its new owners at HKE are finally taking the issue seriously.  On July 1, LME announced a new proposal to adjust load-out rules.

And the drumbeat calling for change is growing louder with a few notable highlights:

  • News reports suggest the Federal Reserve is reviewing the full scope of banks’ activities in the physical markets.
  • The New York Times published a Sunday cover story this week breaking down the warehousing system that it states “ultimately costs consumers billions of dollars”.
  • This Tuesday, the Senate Banking Committee will hold its first hearing to look at banks’ control of commodity storage.

As a reminder, the aluminum industry is currently faced with the highest spot premiums in history at a time when stocks are also at an all-time high (Note the spot premium is the extra cost, over the LME price to secure metal at a suitable location). The LME warehouse minimum load-out rate rule lies at the heart of the issue. Warehouses are able to ingest metal at a seemingly infinite rate while they release metal at the minimum load-out rate of just 3,000 metric tons per day in warehouses with stocks greater than 900,000 tons. The two warehouse complexes in question are Metro in Detroit, owned by Goldman Sachs, and Pacorini in Vlissingen NL, owned by Glencore.  In June of this year, for example, Detroit absorbed 180,000 tons in three days and Vlissingen reported increases of more than 10,000 tons on seven separate days.   On July 1, the combined warehouses accounted for a whopping 3.5 million tons of the 5.5 million tons received in all LME warehouses around the world.   If you want to get metal from either warehouse you have to wait at least 19 months.

Why are the stocks in Detroit so high? The warehouse owner estimates the length of time that rent-generating metal can be expected to be sit in the warehouse at a rental rate around 45 cents per day. They can take a significant portion of this future revenue and offer incentive payments to producers to encourage them to sell on the LME and ship to their warehouse instead of selling to a physical consumer or trader. This is convenient for producers because it effectively removes spot metal from their inventory.  As the metal languishes in a warehouse, it is unable to circulate, which in turn keeps the physical market fairly tight. The warehouse incentives are directly responsible for driving local market premiums to the highest levels in history at a time when stocks are also at the highest levels ever.

LME proposal

The LME finally conceded that something had to be done and proposed changes to the load-out rules on July 1.  If approved, these new rules would take effect in April 2014.  The premise of the change is to bring more balance between the load-in capability and the load-out requirements. While this latest proposal could shift the market in the right direction, it is complex and will be difficult to administer and enforce.  However, we believe these changes would dampen the appetite of LME warehouse owners to bid for metal and this should begin to normalize local market premiums over time.

The LME could have gone further and moved faster in its latest proposal.  A more direct approach, for example, would have been to ban warehouses from charging rent a month after the buyer has asked to collect it from the warehouse, or create a more direct linkage between stocks held and the load-out requirement (for example, not greater than 0.5 or 1.0 percent per day). The LME could also look at capping the storage allowed in any owner complex in a particular location, like Metro in Detroit.  Novelis will propose and aggressively advocate its ideas to the LME in the coming weeks as part of the ongoing consultation process.

Not so simple

While we have been critical of the LME’s reluctance to take more aggressive action on the load-out rate, I appreciate their predicament.  As the LME stated when announcing the proposal, they can already see potential issues developing in the future.

So it seems that the LME is trying to steer through a range of potential problems that any single solution might create. Why is this? It is my belief that there are financial players in the metal market who have an unfair advantage over regular physical users of the market. For example, certain banks may have LME brokerage, physical trading, warehousing operations and access to finance. Trading companies may not be LME brokers, but possess other attributes and may offer OTC premium deals or fixed pricing on the back of their LME trades or physical books. The combination of multiple levers in the market gives them an edge over other users and it is this edge that creates a conundrum for the LME. No matter what the LME does, these market participants may find gaps, flaws and loopholes in any new proposal and can combine their levers to generate value for themselves at the expense of others.  This is the real issue.

And why can they do this?  Gaps in the regulatory framework exist today. Novelis and others have been in talks with regulators on both sides of the Atlantic in recent months and my conclusion is that warehousing and more broadly, commodities, are outside the normal scope of these regulators.  This is why the LME has such difficulties in finding a solution to this challenging issue.  In this under-regulated market, the players with all the levers have too many opportunities to generate value for themselves.

So what is the solution?
The ultimate solution is either to increase the scope of regulation or prohibit these financial institutions from participating in unregulated markets in the first place.  It seems very severe and would have a detrimental impact, not just on the banks but also on other market participants who benefit from the more benign banking activities in the physical market such as financing, consigning stock and making premium markets, for example.

For me, the warehousing issue is the last straw. It inflates premiums and creates unacceptable supply chain risks. As an illustration, Novelis is about to commission a six-fold expansion of our aluminum automotive sheet capacity in North America at our plant in Oswego, New York.  We have invested more than $200 million, created more than 100 jobs and will supply the massive demand for aluminum in the automotive industry over the coming years.  Imagine if we have to suspend operations at the plant, send employees home and shut down production lines at automakers because we have run out of metal we own, which is stored in a Detroit warehouse, but is inaccessible to us for several months.  While an extreme example, it demonstrates a situation that has already gone too far.

In my opinion, the Federal Reserve announcement on Friday, July 19, and the Senate Banking Committee hearing on Tuesday, July 22, mark the beginning of the end for the warehousing issue and may have far more painful implications for the banks in the future.  It didn’t have to come this far if the LME had acted more seriously two years ago when presented with the potential risks and obvious solutions.

What do you think? Leave your opinion in the comments section below.